Tuesday, April 17, 2012

VC SIGNALING IS SCREWING UP THE ABILITY OF SOME COMPANIES TO RAISE A SERIES A

"I believe they have seed money from [VC FIRM NAME REDACTED]. We generally don't talk to startups that have taken seed money from institutional VCs – we think its a bad idea for the entrepreneur and it creates a tough dynamic for us (either we are a stalking horse for the existing investor or there is some reason the existing investor doesn't want to invest)."

- Recent email from a senior VC partner to me.

Dear Entrepreneur - remember that TechCrunch story you placed about your funding round that mentioned the VCs who invested in your seed round? Unfortunately that TechCrunch (or VentureBeat, or PandoDaily, or GigaOm, or AllThingsD) announcement may be about to bite you in the ass, big time.

While this will not occur to all entrepreneurs taking VC money as a small part of their seed (and in some cases the VCs may be quite helpful), I have seen a number of situations lately where the VC signal has hurt the entrepreneurs ability to raise a Series A. The key is to be thoughtful about who you take money from, how they will help you, and ultimately, ways to mitigate the signaling if you do end up taking VC money.

SOME BACKGROUND ON SIGNALING
I have previously written about the costs and benefits of letting a VC into your seed round. Over the last 18-24 months a number of VCs [1] have started making small investments ($100K to $500K) in a large number of early stage companies. Some individual VC firms have made (my guesstimate) on the order of 50-100+ of these.

Unfortunately, a number of the startups who took VC money in their seed stage are now running into signaling issues - which makes it much harder for them to raise a series A round. A number of companies I know have had their series A round fall apart due to VC signaling. Other smart investors such as Chris Dixon have pointed out this increase in signaling as well.

Why VCs Make Lots of Small Investments - Option ValueVC economics suggest that a small amount of money does not matter much to a VC with a large fund. For example, for a $500 million fund, making 100 investments of $100K each is only $10 million, or 2% of the fund.

In contrast, only a dozen or so startups started each year really matter to a VC from a financial return perspective. A VC needs to own a large percentage (e.g. 20-40%) of a company with an exit in the hundreds of millions of dollars in order to have a chance of returning the money in their fund (much less making the bilions of dollars that is the multiple of the fund they aspire to return).

To a VC, having the inside scoop or relationship to a large number of startups is therefore worth a lot more then the $10-$20 million more and more funds are putting aside to make dozens or hundreds of small investments. Getting to know the founders, being on the startups investor update emails (and learning who is doing well or poorly), or alternatively, having transparency into when the founders are raising their series A round are all type of relationship and information access the VCs crave.

By making lots and lots of small investments, the VCs have these relationships and more information access. The VCs are basically buying a bunch of options on a big part of the Silicon Valley startup scene.

HOW TAKING VC MONEY IN A SEED CAN HURT STARTUPS
While this trend is great for VCs, it is on average bad for the entrepreneurs taking their money. Short term, it seems great ("higher valuation?? fewer people to raise money from?? great!") but long term it backfires ("no one will fund my series A??")

The unfortunate issue for entrepreneurs is that having a VC invest in your seed round can come back to haunt you when you raise a Series A.

Once you go out to raise a series A round, there are three potential scenarios in terms of the state of your startup:1. The company has true breakout traction. This is like 1% of startups. These startups can set whatever terms they want irrespective of signal.2. The company is doing OK, but not breaking out in any obvious way. This is most startups.3. The startup is obviously failing. This startup will soon die and is irrelevant for the purpose of this post.

For companies in bucket 2, which is most companies, any sign of weakness can ruin the company's ability to raise more money. Not raising more money means a startup either dies, becomes profitable, or needs to sell. For most company, this means death or early exit.

Unfortunately, having a VC in your round creates that signal of weakness that, all else being equal, may get in the way of you successfully closing a round. In particular, if the VC who invested in your seed does not pursue you for a series A, then all the other VCs will view this as a sign that your company is not good. The reasoning is that the VC in your seed should know you better then anyone else. If your seed round VC is passing on your company, then other VCs think it is probably a bad investment.

Now, the numbers are against you. If a venture fund does 30 seed investments a year, but only 10 series A (including companies they did not seed invest in), then this means AT MOST 1 out of 3 startups will get a follow on investment. This means the majority of companies that take VC money in their seed will have negative signaling.

THINGS THAT EXACERBATE A NEGATIVE SIGNAL1. A top tier venture firm investing.
As Dixon points out,[4] top tier firms send larger negative signals than lower tier VCs. If one of the better known firms passed on you, the lesser known firms will be more likely to pass too. This does not hold as true the other way around.

When raising a series A, most venture funds don't know whether a VC has passed on you or not. However, if a TechCrunch post has been published with your seed funding announcement mentioning your VC investors, all the other VCs will see this when researching your company. They will all call up your seed investor VC to ask about the company and whether that VC is trying to invest in you. If the answer is "no", a strong negative signal has been sent to everyone else. Remember VCs are constantly calling each other for opinions [2].

2. Having multiple VCs in your round.
Having one VC from you seed pass on you is something you can explain away (see below). Having 3 VCs in your seed all pass on your series A is not explainable.

3. The VC investing larger amounts in your seed.
If a VC invests $100K in your seed, you can try to explain it away as so small an amount that they never spent time with you. A $500K investment suggests the VC spent more time with you. This means that the VC passing on your series A is sending an even bigger signal that your company is not worth pursuing.

HOW TO GET AROUND SIGNALING1. Claim the VC has made a competitive investment.
If the VC has to pass on you due to a competitive situation, then the signal goes away. Find something in the VCs portfolio that helps explain why the VC can not invest in you.

2. Point out the VC has spent zero time with you.
The VC signal is driven by the fact that the VC knows you well and has still decided to pass. Given the large number of seed investments these VCs are making, it is often truthful to point out that the VC really spent 0 time with you and has no proprietary information. (Which raises the question - why did you have them invest again?).

You can also point out that the VC has done a very large number of seed investments, and the partners are thus way over committed.

3. Get the VC to say they are still considering you for investment.
If you can, get the VC to agree to a pro rata in your series A [3]. This will allow you to truthfully state you are still talking with them about investment (even if they don't plan to lead).

4. Raise a bridge.
Raising a bridge round from angels or smaller funds helps wipe the signal clean as your latest round will no longer inclue the VC. Downside is that bridges often occur at a lower valuation and are more dilutive.

WHY ENTREPRENEURS (SOMETIMES) TAKE VC MONEY IN THEIR SEED
As an entrepreneur, you are usually tempted to take VC money in a seed round for one of the following options:

Round size. As seed rounds have grown from ~$500K to >>$1 million in size (in part due to valuations going up) it is harder to find enough people who can write large enough checks to fill your round. Some entrepreneurs add venture firms to the round to fill the round quickly.

Price insensitivity. VCs are really price insensitive in a seed round. They are viewing your seed as a way to get the inside scoop on your eventual series A, and $100K really does not matter to them from a fund perspective. This means the overall valuation of your company will often go up if VCs participate.

Brand. Some entrepreneurs get enamored with the VC brand and the bragging rights that come with it, or think the brand association of the VC will help them hire people. In some cases this can be helpful, in some cases not (depending in part on how many seeds the VC has done).

Connections and help. VCs promise connections and company building help. Unfortunately, if a VC has made 30 or 40 or 50 investments all of $100K size in the past year, they will not be able to help all the startups equally. Many VCs are also more likely to prioritize their "day job" of startups where they sit on the board and own 20% of the company over a startup where they own a few %. Some VCs actually come through on connections or advice in a big way, but many don't (this is also true frankly of angels with a lot of investments). Do your diligence to see how helpful the VCs have been in the past to companies that they make small investments in.

Pre-emptive bids. Sometimes, having a VC in your seed leads them to overpay early for your series A, sparing you the pain of having to run a full blown fund raise.

SUMMARY
A large number of seed rounds in the last 12-18 months have included traditional venture funds as investors. Sometimes having a VC in your seed can be super helpful. However, a number of the the companies who raised from VCs are now regretting it, as having a VC in your seed round can backfire. There are a number of ways to mitigate this signaling risk.

NOTES
[1] By "VC" I mean a traditional, large venture capital fund that invests in series A-C rounds and will compete for a series A against other VCs. I think that the "super angels", which are really early stage VCs, are safe to take money from for a seed round. Although they compete with each other on seed rounds, they typically do not also do series A, so there is no signaling risk associated with them.

[2] VCs call each other a lot. This is odd given that they are all competing for the same financing rounds. In some cases, this is professional courtesy - e.g. to offer an existing investor a pro rata. Or it could be that they already sit on another company's board together, and your company comes up while they are talking about shared business. But fundamentally it is also often a way for a number of people with herd mentality to compare notes.

[3] "Pro rata" means the VC invests enough in the new round to maintain their original ownership stake in the company. E.g. if they bought 5% in the seed, they invest enough money in the series A to not get diluted, and thus they maintain their 5% stake.

[4] I find that sometimes I will have a blog post written, not post it, and then Chris Dixon will publish something with many of the same points (often, better written). This signaling post is a good example of overlap in perspectives, that took me a while to actually post.

Thanks to Hiten Shah for suggesting I go ahead and publish this post anyways.

Thursday, April 12, 2012

Your company culture is the foundation on which everything you do rests. Your culture acts as an unwritten set of rules that drives behavior and cohesion across the company.

Cohesive, insular cultures are more resilient and can withstand shocks to it (e.g. pivoting multiple times) as well as can be extremely motivational / draw out the best in people (e.g. engineers at Palintir sleeping under their desks in their belief they are helping national security, the emergence of Google's "don't be evil" doctrine).

Bad Culture Fits Lead To Pain
Most companies do a poor job of enforcing a common culture or are willing to sacrifice the cultural aspects of who they hire in order to "get someone effective" or "to fill a need". This typically backfires in a big way over the short to medium term. Every single founder I know who has compromised on culture fit has regretted it due to the disruptions it has caused their company (having to fire the bad fits, creating a crappy work environment, good people quitting, trust eroding between co-workers, product moving in the wrong direction, bad actors building power bases, misaligned incentives emerging in the organization, etc.)

Have strong hiring filters in place. Explicitly filter for people with common outlooks and values early.

Hire lots of relatively inexperienced people as you scale. You can indoctrinate people who grow up in your culture more easily then people who grew up in someone else's company culture (especially when experienced folks come in the door with negative cultural baggage).

Constantly emphasize values day to day. Be repetitious until you are blue in the face. The second you are really sick of saying the same thing over and over you will find people have started repeating it back to you.

Reward people based on performance & culture fit. People should be rewarded (promotions, financially, etc.) on both productivity and culture.

This post focuses on (1) above - hiring filters you can use to find great culture fits.

Hiring For Culture Fit
For an early stage, raw startup, your hiring focus should be on homogeneity. You should be encouraging a diversity of origins (gender, ethnicity, etc.) while discouraging a diversity in company values. Max Levchin put it on Quora "Having a highly homogeneous (background, education, values, preferences, etc) very early team is better than not -- cuts down on time-wasting arguments."

An early stage company is a fragile and having people pulling in different directions, or wasting time in pointless philosophical arguments, can be lethal. Early on, you want to hire people with common perspectives and goals who are all pulling in the same direction. (Note: this does not mean want you want clones or group think).

1. Determine the sort of people you want to hire.
Many culture evolve organically based on the first few hires you make. As company founders, you should actively shape this. Ask yourselves the following questions, and get agreement amongst the founders:a. What are the key cornerstones of your company's culture? What sort of values do you want people you hire to have? b. What are you willing to compromise on? What are you not? (Note: if you are willing to compromise on it, it is not important to you).c. How do you plan to screen for people with these values in your interviews? What questions do you plan to ask at each stage to surface their values?d. Are there common backgrounds or resume signals you want to use as filters? (e.g. "built cool stuff on the side in college" (Facebook) versus "ivy league education, double major, and 4.0 GPA" (Google)).

2. Ask culturally relevant questions often and early in your hiring process.
For phone screens at Mixer Labs/GeoAPI (the company I started that Twitter acquired), I would ask candidates 2 basic types of questions before passing them on for an engineering interview:a. Basic technical competency questions.b. Culture fit questions.

My questions were focused on things like the person's productivity, motivations, aspirations, accomplishments (e.g. what they were most proud of, had uniquely pulled off, etc.), analytical approach, design sense, and working style (are they structured? etc.). I would also ask for an explicit view on cultural traits they valued.

In the background, I would look for red flags in the person's personality, working style, and motivations that would come up in the conversation. Some red flags for me:

People whose primary motivation was cash. For Mixer Labs, we wanted people motivated by the impact they could have (and rewarded people richly with equity). Cash focused people may make bad decisions when trading off financial decisions versus other stuff (see e.g. parts of the banking industry).

People who were smart, but not as smart as they thought they were. E.g. if asked a simple brain teaser, the smartest people wrote down the question and worked through it. The people who thought they were smartest would try to do it in their heads and get it wrong.

People who would create a bad environment for the early team (low energy or negative outlook, needlessly argumentative, focused on philosophy over pragmatism, etc.).

People no one wanted to spend time with. This is known as the "airport test". E.g. if you were on a business trip with the person and the plane was delayed - would you be happy to hang out with them at the airport? If not, why do you want to have them in your office every day?

If people seemed technically great but a bad fit culturally, we would ding them immediately.

3. Ask the interviewers for their view of the person from a culture fit perspective.
When assessing the candidate after an interview, we would ask people on our team to weigh in on the culture fit of the candidate, and whether people would want to work with them. This served two implicit purposes:a. To screen the candidate for culture fitb. To re-emphasize cultural values to the broader team

You should be explicit about the type of culture you are trying to build and the type of people you want to hire. By "explicit", I dont mean having a sign pasted up in a 5 person startup with a list of your values. Rather, I mean make the hiring huddles an opportunity to re-emphasize to everyone on the team what is important to the company culturally.

This constant re-emphasis of cultural values is key as the company starts to scale rapidly and grow (future blog post on this coming - see also example below under (4)).

4. Take people out for a "beer" test as part of interviews.
We would take every candidate to some social outing (typically dinner or beer after work). In a startup, people work long hours and you want to make sure people fit in and the team and create an even awesomer [1] environment.

Intriguingly, in a "social" environment, the candidate would often show more of their "true colors". Especially if beer was involved. This often happened before any beer was drunken - I think it was just a shift to a more social context from a work one that triggered behavioral changes.

A great example is a candidate we rejected post beer test, who was one of the strongest engineers technically that we had ever interviewed. However, once we made it to the bar he made a lot of really bad off-color jokes that crossed the line and made the team uncomfortable about him.

When we told our then 2-person team we were going to reject the candidate (who would have increased productivity by 50% single handedly!), one of our employees literally said "wow, you really are serious about trying to build a big company". He saw that we were willing to trade off a great engineer in a competitive environment for maintaining the right culture for us. This impacted the way that he approached interviews from that point on. Our example of trading off short term productivity for the right long term DNA resonated with him and changed his behavior.

5. Have them work out of your office.
Another way to see if a candidate is a good fit is have them come work out of your office for a half day. In one case, for Mixer Labs, a designer candidate offered to take a week off to work out of our offices to see how we would all work together (we paid her for her time). This allows you to spend more time with the person in a work-ish environment to see if they are a good fit.

6. Optimize for the long term.
Every founder has that moment of temptation. There is a big hole you want to fill. You have been looking for the right candidate for too long and can't find them. Or, even worse, you find someone great for the role, but they seem borderline or outright bad culturally.

The right strategy is to not hire the person. "If there is a doubt, there is no doubt" unfortunately proves itself to be true over and over again.